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Scoff at bond funds? Try an index bond fund instead

It's de rigueur for veteran investors to slag bond funds, but let's say you're one of the many people who buy them anyway.

Have you considered an index bond fund? You should, because these funds are among the more reliable performers out there in the fixed-income area.

Probably, you associate indexing with the stock markets. That's understandable because indexing is primarily used to allow investors to achieve roughly the same returns as dozens of major stock indexes in Canada, the United States and around the world.

Indexing also works with bonds, though. Works quite well, in fact.

Index bond funds generally track the Scotia McLeod universe bond index, which is the most widely followed indicator for the fixed-income market in Canada. The performance of federal government, provincial, municipal and corporate bonds are all considered in this index. There's also a foreign index bond fund offered by CIBC Securities that tracks the J.P. Morgan global government bond index.

Ideally, investors holding an index bond fund would make the return of the target index, minus their fund's management expense ratio. If the index made 6 per cent and a fund's MER was 0.5 per cent, then the return to the investor would be something like 5.5 per cent. Simple.

Now, let's see how this works in the real world. The $377-million CIBC Canadian Bond Index Fund has a three-year compound average annual return of 6.8 per cent to Aug. 31, while the total return version of the Scotia McLeod index (includes capital gains on bonds as well as interest) made 7.6 per cent. That's a difference of 0.8 of a percentage point, which is not too far off the 0.97-per-cent MER of this fund.

If you're not impressed, then you haven't looked at the performance numbers turned in by rank-and-file bond funds over the past three years (a three-year time frame was used here because most bond index funds are too new to have long-term track records).

Fact is, not many such bond funds come anywhere near the ScotiaMcLeod index with their returns. Over the past three years, the average bond fund return was 5.6 per cent, or two percentage points lower than the index.

Off the top, I mentioned that index bond funds were reliable. You'll see this in the fact that bond index funds perennially appear in the top half of bond performers on an annual basis. Now, that's consistency.

Bond index funds are available from bank fund families, specifically Scotia Securities, CIBC Securities, RBC Funds and TD Asset Management.

As with any index fund, an important consideration in choosing one of these bond funds is the size of the MER.

The low-cost player is TD's e-fund version of the TD Canadian Government Bond Index Fund, which has an MER of just 0.47 per cent (this fund is available only over the Internet through TD or on-line broker TD Waterhouse). The remaining funds range from 0.72 per cent to 1.02 per cent.

Exchange-traded funds are an alternative to index funds when indexing the stock markets, and the same holds true for bonds.

A sort of quasi-indexing system is used by a pair of bond ETFs, the iUnits Government of Canada Five-Year Bond Fund, or iG5, and a 10-year version called the iG10. Both trade on the Toronto Stock Exchange under the symbols XGV and XGX, respectively.

Both funds are operated in a way that provides investors with a comparable yield to five- and 10-year Government of Canada bonds. The iG5, for example, would hold a bond with five years to maturity, then sell it a year or so later and buy a new bond with five years to go.

For small investors, these ETFs are a good substitute for actual five- and 10-year Canada bonds because they benefit from the better pricing accorded a big institutional investor like Barclays as opposed to a small retail client. The lower the price you pay for a bond, the higher your yield. As well, these funds offer a comparatively low MER of 0.25 per cent.

Some investors may have been turned off index investing over the past couple of years because the major stock indexes have, in some cases, fallen more than actively managed funds, where the manager selects stocks as opposed to buying the stocks in an index.

This is less of a concern with bonds, which aren't as volatile as stocks and offer fewer strategic options for managers to use in fighting a bear market. In 1999, a down year for bond funds, each of the four index bond funds available at the time were a little better than average with their returns.

Bond funds may not be the perfect way to add a fixed-income component to your portfolio, but they do offer convenience. With index bond funds, you also get reliable performance.
rcarrick@globeandmail.ca

© 2007 The Globe and Mail. All rights reserved.

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